Financial Management

PONJESLY COLLEGE OF ENGINEERING Nagercoil 600 003

DEPARTMENT OF MANAGEMENT STUDIES II YEAR MBA / II SEMESTER / BA 7202 FINANCIAL MANAGEMENT STUDY MATERIAL

Faculty In-Charge

G.Arumugasamy Associate Professor in Management Studies

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FINANCIAL MANAGEMENT
UNIT I

FOUNDATIONS OF FINANCE
What is Financial Management? Financial Management that management activity which is concerned with the planning and controlling of the financial resources of the firm financial mgt provides with mgt with vital information for planning and controlling the business and to maximize the wealth of the firm. What are the financial functions? Functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders are known as financing functions. While performing these functions a firm attempts to balance cash inflows and outflows. Finance functions or decisions include: a) Investment or long term asset mix decision b) Financing or capital mix decisions c) Dividend or profit allocation decisions A firm perform finance functions simultaneously and continuously in the normal course of the business. Finance functions call for skilful planning control and execution of firms activities. What is profit maximization? The financial goal of a firm should be the maximization of owners economic welfare. Owners economic welfare could be maximized by maximizing the shareholders wealth. Profit Maximization Profit maximization means maximizing the rupee income of firms produces goal and service. They may functions in a market economy or in a government controlled economy. In a market economy prices of goods and service are determined in competitive markets firms in a market economy are expected to produce goods and services desired by society as efficiency as possible. Price system directs managerial efforts towards more profitable goods or services. Prices are determined by the demand and supply conditions as well as the competitive for us they guide the allocation of resources for various productive activities. In the economic theory the behaviour of a firm is analyzed in terms of profit maximization while maximizing profits a firm either produces maximum output for a given amount of it is assumed to profit maximization is efficiency. It is assumed to cause the efficient allocation of resources under the competitive market conditions and profit is considered as the most appropriate measure of a firms performance.

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Wealth Maximization The objective of shareholders wealth maximization is an appropriate and operationally feasible criterion to choose among the alternative financial actions. Shareholders wealth maximization means maximizing the net present value of a course of action to shareholders. The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action resulting on negative NPV should be rejected. Maximizing shareholders economic welfare is equivalent to maximizing the utility of their consumption overtime with the wealth maximized shareholders can adjust their cash flows in such a way as to optimize their consumption. From the shareholders point of view the wealth created by a company through the actions reflected in the market value of the companies share. The wealth maximization principle implies that the functional objectives of a firm are to maximize the market value of its shares. The value of the company share is represented by the market price which is the reflection of the financial decision of a firm. State the managerial uses of financial datas Accounting is the guide post for management. A firm should know the financial implications of its operations. Accounting system keeps the financial score of the business. If points out the problems faced by likely to be faced by the firm. It also brings to its notice opportunities that are likely to arise. It indicates possible action when needed. Managerial Uses The mgt uses the financial statements for the following purposes 1) Making decisions concerning the use of limited resources, including the identification of crucial decision areas and determination of objectives and goals. 2) Effectively directing and controlling the human and material resources of the business. 3) Maintaining and reporting the custodianship of resources 4) Facilitating social functions and control. The main object of accounting is to provide vital information to the mgt to make relevant decisions and form judgments. Accounting has to perform there functions in providing information to mgt. a) accumulation of information b) measurement of information c) communication of information Accounting is a service activity. Its functions is to provide quantitative information primarily financial in nature, about economic entities that are indented to be useful in making economic decisions in making reasoned choices among alternative course of action.

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UNIT II

INVESTMENT DECISIONS
What is Capital Budgeting? Capital Budgeting is the process of selection of investment proposals which are worthwhile for investing the available funds. Capital Budgeting consists of invertible funds, Selection of investment projects planning and control of capital expenditure whose returns stretch them selves over a long gestation period. What are the objectives of capital budgeting? 1. The primary objective of Capital Budgeting is to spread the available invertible over the capital projects in such an optimum combination as to maximize the total profits occurring from all the investment put together. 2. n addition to the profit maximization objective , capital has also other objectives such as employment generation , provision for research and development and the like . 3. Capital Budgeting also aims at controlling capital expenditure. 4. Capital Budgeting determines the total amount of money in the invested as long term projects, so that it may be controlled in line with the companys financial policies. 5. Capital Budgeting also tries to compromise the availability of funds and requirements of capital projects. What are the factors that complicate the process of Capital Budgeting? Planning, forecasting, budgeting and financing of capital expenditure projects from a vital part of management. Top management takes personal interest and direct control over investment decisions because of the following aspects which makes the process of Capital Budgeting more complicated. a) Huge Amount: The amount of money to be invested in capital projects over huge. While finance is scarce in relation to its demand, investment decisions involving huge amounts will really prove to be a tough job. b) Longer Period of Time: As a huge amount of investment is locked up for a longer period of time, the greater is the risk assumed. c) Different points of time: Investments and returns over different points of time take place, evaluation of projects make more complicated. d) Methods of Capital Budgeting: There are various techniques to evaluate the profitability of a project, each are supplied under special requirements, of the circumstances. The result will not be uniform under all the methods. So contra very may arise as to which particular method should be used. e) Future outcome of investment: Capital investment decisions are for long time in nature whereby future outcome of the investment is affected by multifarious factors. So current assessment of future return will pose different problems. f) Social Benefits: Incase of public enterprises, in addition to the economic consideration, social benefits of such investment should also be considered. g) Political Influence: In certain cases the political influence may influence the decisions . h) Availability of Funds: Capital Budgeting decisions are very much influence by the availability of funds. i) Time of Investment and return: It differs or when the time lag between them widens, problems may be caused in adjusting the returns according to price levels.
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j) Impediments: When the rate of return, depreciation, expected earning differs between two projects, impediments may also be caused. What are the various methods of Capital Budgeting Appraisal? The various methods of Capital Budgeting can be broadly classified into 1. Methods not considering time element 2. Methods considering time element Methods not considering time element: This group includes the following two methods a) Pay Back Method b) Analysis Rate of Return Method Methods considering time element: This group includes the following two methods a) Net Present Value Method b) Internal Rate of Return Method Pay Back Method: This is the most simple but unrealized method. Under this method, the period taken by the project to recover the investment amount from its future earnings. Pay Back Period = Amount Invested Constant annual earnings The earnings after this period will constitute profits. Thus this method tries to equate the revenue and the capital expenditure over a period of time. In other words, this ascertains period of time required for annual earnings of the project to equate with the initial investment. The earnings here refer to the profits earned by the project before charging depreciation but after deducting the operating expenses and tax. This method is useful when finance is scare and when the management to anxious to plough back the money on then the projects awaiting investment. Average Rate of Return Method: This method is nothing but an extension of the pay back method. Under this method, an attempt is made to calculate profits of a particular project earned over its whole working life . The average rate of return method consists of taking all the earnings after depreciation and dividing them by the projects working life. Average Rate of Return = Average Annual Net Profit * 100 Average Investment Average Investment = Opening Investment + Closing Investment 2 Thus the average rate of return method is an accounting method which represents the ratio of average investment in the project. Acceptable projects are ranked according their respective rate of return. Net Present Value Method: This method is based on the concept that a rupee received today is not the same as a rupee received at the end of the year. Under this method the present values of the future earnings spread over a number of years either evenly or unevenly. Then the sum total of these discounted earnings will be compared with the actual investment to find out the surplus. The net present value method is superior to other methods as it takes into account both the magnitude and the timing of cash flows over the effective life of the asset.
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Internal Rate of Return: The internal rate of return is the discount at which the net present value of the projects is zero. Under IRR rule, the project will be acceptable when the internal rate of return is higher than the opportunity cost of capital. The IRR rule gives a misleading signal for mutually exclusive projects. The IRR rule also yield multiple rates of return for conventional projects and fails to work under varying cost of capital conditions. RATIO ANALYSIS What is Ratio Analysis? Ratio is simply the quotient of two numbers. It is almost meaningless by itself. For an accounting ratio to have meaning it must be interpreted against some standard. Usefulness of Accounting Ratios: 1. Accounting Ratios are very useful for forecasting trends in cost, sales, profit and other relevant. 2. By accounting ratios, the plans made can be guidelines. 3. To establish desirable coordination or balance they may be used. 4. Control of performance and control of costs may be materially assisted by accounting ratios. 5. Ratios may be used as measures of efficiency for inter-firm and intra-firm comparison 6. Ratios can play a vital role in what has happened. Limitations: 1. Ratio suffers from the inherent weakness of account system as the accounting which is the source of data has some flows. 2. Ratios compared from single set of figures will not have much significance. 3. Ratios are clues and not bases for immediate conclusions. 4. Conclusions from analysis of statements are not sure indicates of bad or good management. 5. Different agencies adopt different definitions and there by making the ratios noncomparable. What are Solvency Ratios? Solvency Ratios are those ratios which are used to test the short term and long term solvency of a business. Short Term Solvency Ratio: Current Ratio Liquid Ratio Debtors Turnover Ratio Long Term Solvency Ratio: Proprietary Ratio Debt Equity Ratio Leverage Ratio etc.

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What are Profitability Ratios? Profitability Ratios are those ratios which are used to determine the profitability or efficiency of a business concern. Ex: Gross Profit Ratio, Net Profit Ratio , Return On Investment What is Financial Leverage Ratio? Financial Leverage is one which is used to establish the relationship between owned funds and borrowed funds. This ratio is also known as trading on Equity. There must be proper and correct relation between borrowed capital and owned capital. Financial Leverage = Operating Leverage = EBIT EBIT Interest & Preference Dividend Contribution Earnings before Interest and Tax

What is DU PONT Chart Profitability? The combined effect of the net profit margin and the capital turnover reveals the return on capital employed and it is considered as the earning power of a business. The combined effect shows the overall picture of the performance of a business which is disclosed by DU PONT Chart. UNIT III

FINANCING AND DIVIDEND DECISION

What is Capital Gearing or Leverage? The term capital gearing or leverage is used to describe the ratio between equity capital and the fixed interest bearing securities of a company. For the calculation of capital gearing ratio, the equity capital includes equity share capital, reserves and undistributed profits. The fixed bearing securities include preference share capital and debentures. Hence it denotes the relation between the total equity and the total of preference share capital and debenture. Capital Gearing Ratio = Equity share capital + Reserves+ Undistributed profit Preference share capital + debentures If the ratio is greater than 2, the capital is said to be low geared, If it is less than 1 the capital is high geared, If it is between 1 and 2 the capital is medium geared. What is over capitalization? A company is said to be over capitalized when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets. In other words, the amount of issued shares and debentures is much more than the requirements and they cannot fetch proper return. Over capitalization is a state of affairs in which dividend rate is too low to sell the shares at their par value. It denotes low Earnings Per Share Ratio and high Proprietary Ratio. Similarly the capital gearing ratio will be low where the current ratio will be high
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Causes of over- Capitalization: 1. When a company issues more shares and debentures than what it needs, it cannot properly utilize the funds and it will lead to over capitalization. 2. Increased preliminary expense at the time of promotion may also lead to over capitalization. 3. Purchasing property at inflated price is also one of the reasons for over capitalization. 4. The wrong estimation of earning capacity and the amount of capital may result in over capitalization. 5. When the company borrows more money from outsiders and pay higher rate of interest on the loan and thereby lead to over capitalization. 6. If adequate provision for depreciation and replacement of assets is not made, it reduces the earning capacity of the company. It is followed by a reduction in the value of share that represents over capitalization. Evil Effects Of Over Capitalization: 1. The confidence of investors in an over capitalization concern is shaken on account of its lower rate of dividend and it is followed by a fall in the market price of shares. 2. Declining earning capacity of the company is shaking the credit standing of the company. 3. Depreciation, renewals and replacement may be starved due to the decrease earning capacity. 4. To boost up profits manipulations of accounts may be done. 5. The share holders of the over capitalized company cannot get adequate dividend. 6. Lower rate of dividend reduces the value of the shares. The share holders find difficult to sell the shares in the market at proper price. 7. An over capitalized company may try to cut the wages of workers and it will create labour problems. 8. Due to decline in efficiency, an over- capitalized concern tries to increase the price and reduce the quality of products, finally this will lead to the liquidation of the company. What is under capitalization? A company is said to be under capitalized when the amount of shares and debentures is less than requirements. Over capitalization is a state of affairs in which dividend rate is too high to sell the share at a premium. It denotes high Earnings Per Share Ratio and Low Proprietary Ratio. Similarly the capital Fearing Ratio will be high where the current Ratio will be low. Causes of under capitalization: 1. Under estimation of the expected earnings at the time of promotion of the company may lead to under - capitalization 2. By adopting latest techniques and other modernization schemes which increases the efficiency of the company. The real value of the concern may exceed its book value. 3. If a company declares dividend, it will find enough money for the pouching back of finance to develop the earning capacity of the company. In the long run it may lead to under capitalization. Evils of under Capitalization: 1. Management of under capitalized concern may be tempered to create secret reserves and thereby oppress the increased profit 2. Increased profit will invite investors to enter into this field.

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3. Higher profit will encourage the workers to claim more wages failing to accept their claims will lead to labour problems. 4. Seeing the excess profit, the consumers may feel that they are overcharged. 5. Government will also charge more taxes in case of higher rate of earnings. CAPITAL STRUCTURE What is Capital Structure? What are its features? Capital Structure refers to the mix of long term sources of funds such as debentures, long-term debt, preference share capital and equity share capital including reserves and surpluses. Some companies do not plan their capital structure. It develops as a result of the financial decision taken by the Financial Manager without any formal planning. These companies may prosper in the short run , but they may face considerable difficulties in raising funds to finance their activities. With unplanned capital structure those companies may also fail to economic the use of their funds. Consequently it is being increasingly realized that a company should plan its capital structure to maximize the use of the funds and to be able to adapt more easily to the changing conditions. Features of Capital Structure: A sound capital structure should having the following features 1. Return: The capital structure of the company should be most advantageous. Subject to other considerations, it should generate maximum returns to the shareholders without adding additional cost. 2. Risk: Debt should not significant risk it should be used otherwise its use should be avoided. 3. Flexibility: The capital structure should be flexible. It should be possible for the company to provide funds whenever needed to finance its profitable activities. 4. Capacity: The capital structure should be determined within the debt capacity of the company. This capacity should not be exceeded. 5. Control: The capital structure should involve risk of loss of control of the company. The owners of closely held companies are particularly concerned about dilution of control. What is Long-term capital? What are its sources? The term Long term capital refers to the funds which remain locked up in the business for a long time. All those assets which are retained permanently in the business are purchased from these funds. Sources of Long Term Capital: Long term finance usually takes two forms a) Shares b) Debentures Shares: Shares are the equal portions of the entire share capital of the company. The persons who hold the shares of a company are called shareholders who are eligible to get dividend from the company on the basis of number of shares held by them. The two main clauses of shares are a. Equity Shares
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b. :Preference Shares Equity Shares: Equity shares may be regarded as the corner stone of financial structure. The majority of the shares issued are equity shares. The holder of equity shares is called Equity Shareholders. The Equity Share capital of a company is non-refundable except when the company goes into liquidation. The Equity Shareholders provide the main risk bearing capital of the business. Hence they are entitled to a share of profits. Preference Shares: The Preference Shares carry certain preferential rights such as a) Preference in payment of dividend and b) Preference in the repayment of capital in case of liquidation of company. The Preference Shares are entitled to a fixed percent of profit of the company. Without declaring dividend to preference share, the Board of Directors cannot declare any dividend to the Equity Shares. Capital raise from internal sources: A new corporate enterprise may be stared by means of external capital but much of its subsequent development proceeds throw self-financing. Savings generated within the corporate units and left in the form of retained earnings constitute the main spring of their expansion. Debentures: A debenture is an acknowledgement of a debt by a company to some person. It is issued to the public by means of prospects in the same manner as shares are issued. It may be secured or unsecured by creating a charge on all assets of the company. The holder of debentures of a corporate enterprises are called debenture holders who are eligible to get interest on fixed percentage . What is Medium Term Capital? What are its sources? According to the State Industrial Corporation in West Bengal, a medium term capital refers to capital that varies for periods from 1 to 10 years. Sources of medium term capital: Sources of Medium Term Capital are hire purchase, equipment, leasing and public deposits. Hire purchase credit: Hire purchase is a method of obtaining assets on payment of a deposit, the balance of the price being spread over a period of a few months. Installments will also include the interest for the amount of principal remaining unpaid at the end of each installment. Equipment leasing: The method of obtaining is just like that of getting a property for rent. There are some companies which buy equipments and lease the same on a contractual basis for a specific period to the needy business houses. Public deposits:

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Now-a-days companies accept fixed deposits from the public for periods ranging from 1 to 3 years. They offer attractive rates of interest varying from 11% to14% depending upon the period of deposit. These deposits form a very convenient source of medium term capital for the companies. The Government regulates this activity by financing rules called Companies Rules 1975. What is Short term capital? What are its sources? According to the Committee on Finance for the private sector in India short term credits are those up to one year. Sources of short term capital: Bank over draft: The most common way of obtaining a short term capital is by means of a bank overdraft. For firms with sufficiently good credit, the bank over draft is an extremely form of finance. The borrower pays only on what he owes at the end of each days business which makes its cheaper than obtaining a loan for a fixed period. Loan from Private Parties: Shot term finance may also be obtained from private parties. But the amount of such accommodations is low and rate of interest is high. Inter-company loans: It has gained importance as a means of finance as companies have become integrated into groups under the same control. Trade debts: Every trading concerns both gives and receives a certain amount of finance in the form of trade debts, for every purchase and sale which is not immediately settled in case creates a temporary debt. COST OF CAPITAL What is cost of capital? The term cost of capital refers to the price that a company has to pay in order to have the use of capital. It should be noted that it is a concept of vital importance in the financial decision making. If is useful for as a standard for a) Evaluating investment decisions. b) Designing a firms debt policy c) Appraising the financial performance of top management. What is Watered Capital or Watered Stock? Watered capital or Watered Stock is that part of capital which is not represented by assets. The introduction of water in the capital happens at the time of promotion of the company. What are current assets? State its characteristics: Current assets refer to those assets of a firm that can be easily converted into cash within a limited period of time. Eg : cash , debtors , bill receivable . Characteristics:
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1. 2. 3. 4. 5.

Current assets can be easily converted into cash. Current assets determine the cash flow of a company. Current assets are the determinants of Working Capital. Without current assets the fixed assets are meaningless. The revenue profit of a business is determined by current assets. DIVIDEND POLICY

What is dividend? A dividend is a share of the divisible profits of a company distributed to the shareholders. Dividends should be paid only out of profits and can never be paid out of capital of the company. The dividends should be paid to the shareholders whose name appears in the register of members of the company or to his banker. The dividend declared by the company is a dept to the shareholders of the company. Explain the forms of dividend? Cash dividend Most companies pay dividend in cash. A company should have enough cash in its declared. If the company does not have enough bank balance arrangement should be made to borrow funds. When the company follows a stable dividend policy it should prepare a cash budget for the coming period to indicate the necessary funds which would be needed to meet the regular dividend payment of the company. When the cash dividend is paid the cash account and reserve account of the company will be reduced. Thus both the total asset and net worth of the company are reduced. The market price of the share drops in most cases by the amt of thecash dividend distributed. Bonus share or stock dividend Bonus shares represent a distribution of share in addition to the cash dividend to the existing shareholders. This has the effect of increasing the number of outstanding shares of the company. The shares are distributed proportionality. Thus a shareholder retains his proportionate ownership of the company. The declaration of bonus share will increase the paid up share capital and reduce the reserves and surplus of the company. The total net worth is not worth is not affected by bonus shares. Bonus issue represents the recapitalization of the owners equity portion. What are the factors that influence the dividend policy? a) Shareholders expectation In the matter of dividend decision the directors should give due importance to the shareholders view. Wealthy shareholders with high income tax bracket may be interested in capital gains, than current dividends. On the other hand a retired person with small means dividend on may not be interested in capital gains. b) Closely held company In case of closely held company the body of the shareholders is small and homogeneous and the expectations of shareholders are usually known to mgt. therefore they can adopt a dividend policy which satisfies more shareholders. If most of shareholders are in high tax bracket and have a preference for capital gains to current dividend incomes, the company can establish a dividend policy of less or no dividends and retaining with in the company.
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c) Widely held company In case of widely held company the body of the shareholders is large and the expectations of the shareholders are not known to the mgt it is not possible to follow a dividend policy by taking in to account the views of the dominating group but does not completely neglect the desires of others. d) Small shareholders Small shareholders hold a small number of shares with the object of getting regular dividends or making capital gains. They do not have a concrete dividend policy. The dividend policy to be formed must take this fact also into consideration. e) Retired and old persons They generally invest in shares with the view of getting regular income. These persons select shares of the companies which pay regular and liberal dividends. This fact should be considered in designing dividends policies. f) Wealthy investors Wealthy investors are much concerned with the dividend policy followed by a company. They have a definite investment policy of increasing wealth and minimizing taxes. The wealthy shareholders group is dominating in many companies as they hold large block of shares. This group will have a considerable influence on the dividend policies of the companies. g) Institutional investors Institutional investors purchase large block of shares to hold them for relatively long period of time. They are not concerned with personal income taxes but with profitable investments. These investors are attracted those dividend policy in accord with their investments requirements. Hence the dividend policy should take in to account the institutional investors also. h) Finance need of the companies Depending upon the needs to finance their investments opportunities companies may follow different dividend policies. i) Legal Restrictions The individual policy of a firm has to be framed within the legal frames and restriction. The companies Act provides that dividend shall be declared or paid only out of current profits or past profits after providing for depreciation. Dividends should be paid in cash but a company is not prohibited to capitalize profits or reserves for the purpose of issuing fully paid bonus shares. Thus the legal rules act as boundaries with in which a company can operate in terms of paying dividends. j) Liquidity The cash position of a firm is an important consideration in paying dividends. A company with greater cash position and overall liquidity will have a greater ability to pay dividends. But an unsound company cannot declare great dividend. k) Financial condition and borrowing capacity

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A high degree of financial leverage makes a company to changes in earnings. It becomes difficult to raise funds externally for financing its growth. A highly levered firm is expected to return more to strengthen its equity base. However a company with steady growing earnings and cash inflow may follow a high dividend payment policy. l) Access to capital market A company that is not sufficiently liquid can pay dividend if it is able to raise debt or equity in the capital markets. Easy accessibility to the capital market provides flexibility to the mgt in paying dividends as well as in meeting the corporate obligations. m) Restrictions in loan Agreement Lenders may generally put restrictions on dividend payments to protect their interest when the firm is experiencing low liquidity or low profitability, when these restrictions are put the company is forced to retain earnings and have a low payout. n) Control The object of maintaining control over the company by the existing mgt group or the body of shareholders can be a important variable in influencing the dividend policy of a company. o) Investment opportunities When investments opportunities occur it is better to follow a policy of paying dividends and raise external funds. p) Inflation Inflation can act as a constraint on paying dividends some companies follow a policy of paying more dividends during high inflation in order to protect the shareholders from the erosion of the real value of dividends. Companies with falling or constant profits may not be able to follow their policy. Explain the stability of dividends Stability of dividends mean regularly in paying some dividend annually even though the amount of dividend may fluctuate over years and may not be related with earnings. There are a number of companies which have rewards of paying dividends for a long unbroken period. Forms of stability of dividend a) Constant dividend per share or dividends rate A number of companies follow the policy of paying a fixed amt per share or fixed rate on paid up capital as dividends every year respective of the fluctuations in earnings. This policy does not imply that the dividends per share or dividend rate will never be increased. When the company reaches new levels of earnings and expect to maintain the earnings the annual dividends per share may be increased. b) Constant payout The ratio of dividend to earnings is known as payout ratio. Some companies may follow a policy of constant payout ratio of paying a fixed percentage of net earnings every year. With this amt of dividend will fluctuate in direct proportion earnings. Small constant dividend per share plus extra dividend Under this constant dividend per share policy the amt of dividend is set at a high level. This policy is usually adopted by companies with stable earnings. The small amt of
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dividend is fixed to reduce the possibility of ever missing a dividend payment. This type of policy enables a company to pay constant amt of dividend regularity without a default and allows a great deal of flexibility for supplementing the income of shareholders only when the earnings of the company is higher. Significance of stability of dividends Stability of dividends has the following advantages 1) Resolution of investors uncertainty. 2) Investors desire for current income 3) Institutional investors requirements 4) Raising additional finances. Explain the various dividend theories a) Walters model theory Professor james E.walter argues that the choice of dividend policies almost always affect the value of the firm. His model clearly shows that relationship between the firms rate of the firm rate of return and its cost of capital in determining the dividend policy that will maximize, the wealth of shareholders. Assumptions a) Internal financing The firm finances all investments through retained earnings or new equity is not issued b) constant return on cost of capital The firms rate of return and cost of capital k are constant c) 100% payout or retention All earnings are either distributed as dividends or reinvested d) constant EPS and DIV Beginning earnings and dividends never change. The values of the earnings per share EPS and the dividend per share DIV may be changed in the model to determine results , but any given values of EPS and DIV assumed to remain constant forever e) Infinite time The firm has very long or infinite life Walter s formula to determine the market price per share P= DIV +(r/k) (EPS-DIV) K In Walters model the dividend policy of the firm depends upon the availability of investments opportunities and the relationship between the firms internal rate of return and its cost of capital Retain all earnings when r>k Distribute all earnings whenr>k Dividend policy has no effect when r>k Thus dividend policy is walters model is a financing decision Critism of Walterss model 1) Walters model of share valuation mixes dividend policy with investments policy of the firm
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2) Walterss model is based on the assumption that is constant. In fact decreases as more and more investment is made. This reflects the assumption that the most profitable investments are made first and then the poorer investment are made b) Gardons model theory One very popular model relating the market value of the firm to dividend policy is developed by Myron Gardon Assumption a) All equity firms. The firm is an all equity firm. It has no dept b) no external financing no external financing is available. Retained earnings would be used to finance any expansion c) Constant return The internal rate of return of the firm is constant d) Constant cost of capital The appropriate discount rate k is for the firm remains constant e) Perpetual earnings The firm and its stream of earnings are perpetual f) no taxes Corporate taxes do not exist g) constant retention The retention ratio is constant. Thus the growth rate is constant for ever. h) cost of capital greater than growth rate The discount rate is greater than growth rate Gardons formula to determine the market price per share According to Gardons dividend capitalization model the market value of the share is equal to the present value of an infinite stream of individuals to be received by the shareholders Po=EPS(1-b) k-br It is revealed that under Gardons Model a) The market value of the share increases with the retention ratio for firms with growth opportunities b) The market value of the share increases with payout ratio for declining firms c) The market value of the share is not affected by dividend Policy when r=k Limitation Gardons model conclusions about dividend policy are similar to that of walters model. Thus the Gardon model suffers from the same limitation as walter model. UNIT IV

WORKING CAPITAL MANAGEMENT

What is Working Capital?

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Working capital is that portion of a business concerns total capital which is employed in short term operations. Without working capital fired capital would be idle and inefficient. Working Capital represents the excess of current assets over current liabilities. Working Capital = Current Assets Current Liabilities Working Capital is described as circulating capital or revolving capital because the working capital is repeatedly invested recovered and re invested as long as the concern is going on. 1) Gross working capital 2) Net working capital Gross working capital Gross working capital refers to the amount invested in current assets such as cash, bank balance, stock, debtors, and bills receivable and short term investments. Net working capital Net working capital refers to excess of current assets over current liabilities. Creditors, bills payable bank overdraft outstanding expenses are the examples of current liabilities. Explain the factors determining Working Capital The quantum of WC varies with the type of business and the objectives of the properties. The estimate of the requirements of WC will differ from concern to concern and from industry to industry. There is no concrete formula to decide the amt of WC required by a business. There are business in which WC is almost negligible while there are others in which the fixed capital is small in relation to WC. The major determinants of WC are a) Nature of business WC of a business depends upon the nature of business. Incase of public undertaking, WC requirements ate very limited. In case of trading and financial firms, the need of WC is high. b) Length of the period of the manufacturing process If the manufacturing process involves longer the period then larger will be the amt of WC , on the other hand if the manufacturing process involves lesser the period lesser will be the amt of WC. c) production policies If a company produces seasonal goods throughout the year to meet the seasonal demand then it may require heavy amt of WC. Incase of labour intensive industries the WC requirements will be more. d) Credit policy When goods are purchased for cash and sold on credit the requirements of WC will be more on the other hand when goods are purchased on credit and sold for cash, and then the requirement for WC will be less WC of a business depends upon the credit period of the transactions. e) Rate of turnover

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A high rate of turnover will need a low amt WC.a low rate of turnover will need a high amt of WC f) Seasonal variance in demand Industries which produce seasonal goods may require high amt of WC g) Trade cycle In times of prosperity there is a need for larger amt of WC due to increased sales rise in prices etc. in times of depression there will be low amt of WC requirements due to low sales volume longer collection period etc. h) Size of business A large scale business may require larger amt of WC where a small scale business nay requires small amt of WC. i) Procurement of raw material Some raw materials may be procured during a particular season only. If so then the amt of WC requirement will be high. If a raw material can be procured at any time then the amt of WC requirement will be less. j) Expansion of business Due to expansion of business activities the WC requirements will be very high. k) Other factors Banking facilities Economic policies of a country Location of industry Import policy Operating efficiency Reputation of the firm. What is the importance of Working Capital? Finance is the blood of every business. If there is any inadequate finance then the business cannot function properly. Therefore there must be sufficient amt of finance. Important uses of WC are 1) To meet out the production process without any delay 2) To get economy in mass production 3) Cash discount and trade discount can be availed. Due to this, production costs are decreased. Owners may receive huge amt of profit and customers may get good quality of goods at reasonable prices. 4) Goodwill of the firm increases 5) Morale and confidence of the firm increases 6) Helps to disburse remuneration to employees in time 7) Increase the sales due to sale of goods on credit 8) Short term solvency of a business can be determined 9) Sufficient amt of raw material is possible. CASH MANAGEMENT What is Cash Management?
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Cash- what a strange commodity a business wants to get hold of in the shortest time possible but to keep the latest possible quantity on hand. If cash is not available in sufficient quantity at the proper time obligations could not be met in time and the company may become insolvent.

Factors involving cash management Cash mgt involves three factors. 1) Determination of the necessary minimum cash balance 2) Arranging the method of collection and payment of cash in such a way that only the minimum balance is maintained 3) To invest the surplus cash in temporary investments or in permanent productive assets Determination of necessary minimum cash balance If depends upon many factors. They are a) Sound credit position of the business b) Purchasing of raw materials on credit basis c) The time required for converting bills receivable in to cash d) The nature of the business e) Maintaining huge quantity of inventory f) Attitude of mgt and g) Amount of sales Mention the various financing policies of current Assets A firm can adopt different financing policies of current assets. The 3 types of financing policies are a) Long term financing: The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowing from financial institutions and reserves and surplus. b) Short term financing: The short financing is obtained for a period less than one year. It is arranged in advance from banks and other suppliers of finance in the money market. Short term finance include WC funds from banks, public deposits, commercial paper, factoring of receivables etc d) Spontaneous financing: refers to automatic sources of short term funds arising in the normal course of business. Trade credit and outstanding expenses are examples of spontaneous financing there is no explicit cost spontaneous financing. A firm is expected to utilize these sources of finance to the fullest extent. e) FUND FLOW STATEMENT AND CASH FLOW STATEMENT A fund flow statement is a statement of sources and application of funds. It is a statement which implies the sources from which funds come into business and the way in which those funds are utilized. It shows the changes in the fixed assets and liabilities during a particular period. Uses 1) It helps to analyze the changes in WC between the two balance sheet data
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2) This statement discloses the changes in the financial position of business. 3) This statement helps to know for the following information a) Aggregate amt of goodwill of the firm b) Means and ways of repayment of borrowed loan c) Changes on profit of the business d) Means of application of funds 4) Fund flow is used as a tool to receive funds and to expend the funds in the best Possible way 5) Fund flow statement is used as a tool to know the changes in WC. What is meant by fund? The term fund in its narrow sense means cash. In a broader sense it refers to money values in whatever form it may exist. Here fund means all the financial resources. In a popular sense funds mean WC What is mean by flow of funds? The term flow means movement or change and includes both inflow and outflow. The term flow of funds mean transfer of economic values from one asset of equity to another. Flow of fund otherwise known as changes in WC of a business. What are the different sources of funds? a) internal sources b) external sources Internal sources Internal sources are the sources which are available within the company or business itself. Eg. Fund from operation External sources External sources are the sources which are available from outside the business eg. Issue of shares and debentures Borrowing long term loans and sale of fixed assets What is mean by schedule of changes in WC? Schedule of changes in WC is a statement which is prepared by comparing the current assets and current liabilities What is cash flow statement? A cash flow statement is a statement which is prepared in order to find out the amt of changes in cash position of a firm from one period to another. In other words cash flow statement is a statement of changes in the financial position of the firm on cash basis. It shows the inflow and outflow of cash. In this cash refers to cash a bank balance What are the uses of cash flow statement? a) It is useful for cash mgt b) It helps to estimate the changes in cash position of a firm c) It helps to prepare cash budget d) For an analysis of short term financial position cash flow is suitable e) It helps to plan repayment of loans purchase of fixed asset etc f) It is very useful to know the liquidity position of the business while making interfere comparison
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g) It helps to disclose all cash transactions h) Cash flow statement reveals the reasons for increase or decree in cash position i) It is very useful for short term planning j) It helps in internal financial mgt k) It is a useful supplementary instrument. What are the limitations of cash flow statement? 1) All transactions cannot be represented in real liquid position 2) A cash flow statement cannot give complete picture of funds 3) A cash flow statement cannot replace an income statement or a fund flow statement 4) It can be used only for a short-term period 5) It is very difficult to define the term cash 6) A cash flow statement does not contain all the necessary information of a financial statement What are the limitations of fund flow statement? 1) It cannot be considered as a substitute of an income statement or balance 2) It is prepared from financial statement the fund flow statement will not reveal a correct picture 3) It cannot be prepared with accuracy because it is based of historical figures 4) Fund flow statement reveals a change of funds between two periods What are the difference between fund flow and cash flow statement? FUNDFLOW STATEMENT 1) Schedule of changes in WC is prepared 2) It relates to changes in WC 3) It is based on accrual basis 4) It is more useful for medium term and long term analysis 5) It does not begin with opening balance of cash 6) It does not end with closing balance of cash 7) Sources and application of funds are considered. CASHFLOW STATEMENT 1) Schedule of changes in WC is not prepared 2) It relates to changes in cash 3) It is based on cash basis of accounting 4) It is useful for short term analysis 5) It begins with opening balance of cash 6) It ends with closing balance of cash 7) Inflow and outflow of funds are considered

UNIT V

LONG TERM SOURCES OF FINANCE

What is Lease? Lease is a contract between leaser, the owner of the asset, and the user of the asset. Under the contract, the owner gives the right to use the asset to the user over on agreed period of time for a consideration called lease rental. The lessee pays the rental to the lesser at regular fixed payments over a period of time at the beginning or at the end of a months, quarter half year or year.

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What are the various types of leases? a. Operating Lease or Service Leasing: Short term cancelable lease agreement is called operating lease convenience and instant services are the hall marks of operating lease. Examples: Tourist renting a car, lease contract for computers. b. Financial Lease: Long term non cancelable lease contracts are known as financial lease. Financial lease amortize the cost of the assets over the term of the lease. They are also called capital or full payout leases .Examples: Plant, Machinery, Land, building, ships. c. Sale and Lease Back : A user may sometimes sell an assets owned by him to the lesser and lease it back from him .Such sale and lease back arrangement may provide substantial tax benefits. Financial lease the maintenance and insurance are normally the responsibility of leaser. Mention the various methods of leasing: Leasing can be evaluated using either a) The equivalent loan method or b) Net advantages of lease method. Equivalent Loan Method: Equivalent Loan is that amount of loan which commits a firm to exactly the same stream of fixed obligations as does the lease liability. Equivalent method of evaluating a financial lease consists of the following: i. Find out the incremental cash flows from leasing ii. Determine the amount of equivalent loan such incremental cash flows can service. iii. Compare the equivalent loan so found with lease finance. If the lease finance is more than equivalent loan, the firm should finance the asset by leasing. Net advantages or Net Present value of leasing: The net advantages of leasing denote the incremental advantage over the net present value of buying the asset through normal financing channels. A positive net advantage of leasing implies that leasing has an advantage over the net present value of the asset as an investment which may itself be either positive or negative. A positive net advantage of leasing does not by itself imply that the asset should be acquired. What is Leverage Lease? In a Leverage Lease, the leaser or makes substantial borrowing even up to 80% of the purchase price of the asset. The leaser claims all tax benefits related to the ownership of the asset. Lenders provide loan on a non recourse basis to the leaser. Their debt is serviced exclusively out of the lease proceeds. To secure the loan provided by lenders , the leaser also agree to give them a mortgage on the assets . What is Leverage Lease? In a Leverage Lease, the leaser or makes substantial borrowing even up to 80% of the purchase price of the asset. The leaser claims all tax benefits related to the ownership of the asset. Lenders provide loan on a non recourse basis to the leaser. Their debt is serviced exclusively out of the lease proceeds. To secure the loan provided by lenders, the leaser also agrees to give them a mortgage on the assets. Thus, lenders have the first claim on the lease payments together with the collateral on the asset lenders will take charge of the asset if the leaser is unable to make lease payments.
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What is Direct Leasing? In a direct lease, the leaser buys the asset and becomes the owner by making the full payment of the asset.

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